Cost allocation and activity based costing - Essay Example

Cost allocation and Activity Based Costing Task Introduction This paper is written with the fundamental intention of shedding more light on the concepts of cost allocation and Activity- Based Costing (ABC). This briefing paper is dependent on the ideas of Alan Vercio and Bill Shower as presented in their 2007 article titled “ABCs of Batch processing” and other sources with pertinent contents. The briefing is inclusive of pertinent challenges, issues and the significance of the article to business organizations. Lastly, slide show contentment has been prepared, which include a sample question and answer on ABC. Below is the briefing. Cost allocation is a concept that refers to the determination of the expenses incurred to offer a service. Costs can be allocated as direct, indirect and incremental costs. In the production process, manufacturers should be able to determine what costs fall under direct, indirect and incremental, in order to facilitate the ascertainment of cost of production. Activity based Costing is a concept that refers to the ascertainment of various activities involved in the production of goods and services. Thereafter, the overhead costs are allocated to each activity and then assigned to the products and services. Traditional costing on the other hand, allocates overhead costs using predetermined rate. That is, there is no allocation of costs on activities prior to the products and services. According to Vercio and Shoemaker (2007), the most accurate method of cost allocation is Activity-Based. Unlike traditional costing method, Activity Based Costing recognizes the fact that, during a production process, not all costs are attributed to the volume of products and services produced. Therefore, Activity Based Costing determines the cost drivers associated with the customers, batches, products and administration related costs directly connected to the units produced. In order to ensure accuracy in cost measurements to facilitate informed decision-making during the production process, the costs that are not related to unit production should be secluded (Vercio & Shoemaker, 2007). In batch processing, the fundamental idea is to reduce the cost of production. For instance, assume producing 100 units of product X in a single process or producing 100 units of the same product in 50 producing processes. From the short illustration, it is more economical to produce 100 units of product X in a single production process. In a batch process, a setup is necessary as a preliminary step to the main process. The activities in the setup process include quality control, data recording and material management. Vercio and Shower assert that the traditional costing method allocates all the overhead costs to the units produced. The following are the main types of setups: operational volume setup, operational time setup, operational control setup, product or conditional setup and customer-based setups (Vercio & Shoemaker, 2007). Some of the costs of these setups, which are not directly attributed to the volume produced, are included as production cost thus leading to cost distortions. Activity-Based Costing method was formulated to help reduce such cost distortions. In ABC, there are different types of activities that have different cost drivers, namely, batch activities, unit activities, product activities and facility activities. Unit activities occur whenever a unit undergoes processing. Batch activities occur whenever a large volume of products undergoes processing. Product activities comprise the activities that must be undertaken to ensure the capacity to produce a product. Lastly, facility, activities comprise of security management, ground management and the plant manager (Vercio & Shoemaker, 2007). The one approach to ABC is the equal assignment of the product-level activity costs to every product. On the other hand, batch level conditional setup costs are allocated to products based on the number of batches produced. However, a higher level of Activity Based Costing requires that the conditional setup be accounted for as product level costs rather than batch level cost. Vercio and Shower assert that there is no regular method for Activity Based Costing. The available approaches to ABC are the cost subsidies and the conditional setup costs. Another cost minimization strategy referred to as a round-trip assignment of conditional setups. Under this strategy, a setup for low-volume production and high-volume configuration setups are charged to the low volume product (Vercio & Shoemaker, 2007). Pertinent challenges First, the process can be complicated, time consuming, especially when it comes to collecting data about the activities, and cost drivers. Second, it can be very expensive to implement the system and lastly, it is difficult to allocate some overhead costs to products (Warren, Reeve & Duchan, 2012). Why the article is important to businesses First, the article provides knowledge, to the companies, about a more accurate method of costing products and services. Second, the article provides a clear point about the existence of different sources of overhead costs. Third, the ABC method makes it easy to identify costly and non-value adding activities, therefore, allowing organization’s managers to focus on cost reduction methods. Lastly, the ABC method sustains other techniques used by an organization’s management, such as the balanced scorecard (Warren, Reeve & Duchan, 2012). The steps involved in Activity Based Costing In order to prepare an Activity Based Costing, one should be familiar with the following terms: activity, activity cost pool and cost drivers. An activity, in this context, is any action, event work or transaction that invites cost in the process of product production or service delivery. Activity cost pool can be defined as the overhead costs attributed to a specific type of activity such as materials ordering costs and machine installation costs. A cost driver is any activity or factor that has a direct cause-effect relationship with the resources used. In order to achieve a successful implementation of Activity Based Costing, the following steps are mandatory: activity identification, resource cost assignment to activities, output identification and the assignment of activity costs to output (Warren, Reeve & Duchan, 2012). During the first step (activity identification), a manufacturing organization should engage in a deeper analysis of the operating process of each responsibility center. Each process might involve one or more activity required to produce an output. During the second step, assignment of resource cost to activities, an organization engages in tracing costs to cost objects in order to ascertain the origins of the costs. Costs can fall under three categories. They include direct, indirect and general costs. Direct costs are those that can directly be linked to an output. Indirect costs are those that cannot be allocated to an individual output for the reason that more than two outputs benefit from them. During the third step, output identification, an organization engages in the identification of activities that use its resources. Lastly, the fourth step, assignment of activity costs to outputs, the activity costs are assigned by activity drivers to the outputs based on the level of demand for such activities (Warren, Reeve & Duchan, 2012). An example of ABC The following is a question that requires the implementation of the ABC method. Traditional predetermined overhead rate Number Machine Produced Product Hours Assemble Setups Packing Total OH 20,000 Regular 7,500 300 300 2,500 8,000 Digital 4,000 1,500 500 1,500 Total 11,500 1,800 800 4,000 Total Costs $40,000 $45,000 $25,000 $8,000 $118,000 Step one: identify and classify major activities (assembling, setups and packing). Step two: identify the cost drivers (regular and digital products). Step three: compute the overhead rate for each pool. Step four: assign overhead costs of products. Solution Consumption Ratios Product Machine Hours Assembling Set Ups Packaging Regular 65% 17% 38% 63% Digital 35% 83% 63% 38% Under machine hours column, 65% = (7500/11,500), 35% = (4,000/11,500). Under assembling column, 17% = (300/1,800), 83% = (1,500/1,800). Under setups, 38% = (300/800), 63% = (500/800). Under packaging, 63% = (2,500/4,000), 38% = (1,500/4,000). Activity Rates Machining $ 3.48 Per Machine Hour Assembling $ 25.00 Per Direct Labour Hour Setting Up $ 25.00 Per Set up Packing $ 2.00 Per Order Activity rates under machining (3.48) = (40,000/11,500). Activity rate under assembling (25) = (45,000/1,800). Activity rate under setting up (25) = (25,000/800). Activity rate under packing (2) = (8,000/4,000). Assigned Overhead using Activity Rates Regular Digital Total Machining $ 26,086.96 $ 13,913.04 $ 40,000.00 Assembling $ 187,500.00 $ 100,000.00 $ 287,500.00 Setting Up $ 187,500.00 $ 100,000.00 $ 287,500.00 Packing $ 15,000.00 $ 8,000.00 $ 23,000.00 Total Assigned $ 416,086.96 $ 221,913.04 $ 638,000.00 Above are the assigned overhead costs using activity rates. Under the column named regular, Cost allocated to machining = (3.48* 7,500). Cost allocated to assembling = (7,500 * 25). Cost allocated to setting up = (7,500* 25). Cost allocated to packing = (2*7,500). Therefore, the total overhead allocation to regular product = $ 416,086.96. On the other hand, under the column digital, Cost allocated to machining = (3.48* 4000). Cost allocated to assembling = (4000 * 25). Cost allocated to setting up = (4000* 25). Cost allocated to packing = (2*4000). Therefore, the total overhead allocation to regular product = $ 221,913.04. Therefore, per unit overhead allocated to regular = (416,086.96/20,000) = $ 20.8 whereas, per unit overhead allocated to digital = (221,913.04/8,000) = $ 27.74. References Vercio Alan & Shoemaker Bill. (2007). Journal of Accountancy: ABCs of Batch Processing. Retrieved from . Warren, Carl S., Reeve, James M., & Duchan Jonathan E. (2012). Financial and managerial accounting. Mason, Ohio: South-Western Cengage Learning. Read More